The Beauty of a Parallel Currency

In an attempt to conserve its dwindling foreign reserves, Ecuadorfloatedits currency, the sucre, last February. The sucre hasn't floated on a seaof tranquility, however. In the past 12 months it has lost more that 70% ofits value against the dollar. To extricate Ecuador from this currencycrisis, President Mahuad announced on Dec. 23, 1999, that he was consideringeither tying the sucre to the dollar via a currency board or dumping thesucre and replacing it with a greenback.

Then late Sunday, the president indicated that he would pursue thedollarization option. Mr. Vogel accurately reports the sentiment of manyeconomists whose claim is that either option "would be nearly impossible forEcuador without massive support from the U.S. and multilateral lenders likethe International Monetary Fund." And that "such support is unlikely unlessEcuador mounts major economic reforms..."

These claims echo what has become an entrenched dogma in Washington,namelythat "a currency board is unlikely to be successful without the solidfundamentals of adequate reserves, fiscal discipline and a strong andwell-managed financial system, in addition to the rule of law" (The AnnualReport of the Council of Economic Advisers, 1999). These preconditions forsuccess are nothing more than a canard thrown up by those who oppose eithercurrency boards or their close cousin, dollarization.

Since currency boards were first introduced in 1849, they havealways metwith success, providing sound, convertible currencies. And in most cases,the currency boards (or "dollarization") were introduced where none of thepreconditions for success existed. That was certainly the case when JohnMaynard Keynes installed North Russia's currency board in 1918. And it hasalso been the case in the 1990s, when Argentina, Estonia, Lithuania,Bulgaria and Bosnia introduced currency boards and Kosovo, East Timor andMontenegro granted foreign currencies legal tender status.

My recent experience in Montenegro, where I am PresidentDjukanovic'sadviser, is edifying. Last year, after enduring the ravages of the world'sworst currency, the Yugoslav dinar, Montenegro decided to introduce a soundmoney regime. Many economists again declared this would be impossiblebecause Montenegro did not satisfy any of the preconditions. On Nov. 2,Montenegro successfully introduced a parallel currency system, one in whichthe German mark was made legal tender and allowed to freely float alongsideMontenegro's other legal money, the dinar. All this was accomplishedquickly and without massive support or guidance from the IMF.

Unfortunately, President Mahuad failed to provide a draft law thatclearlyspells out exactly how Ecuador should go about dollarizing its economy. Inlight of its meager foreign reserves, Ecuador should follow Montenegro'slead and introduce a parallel currency system. This could be accomplishedby allowing the Ecuadorian sucre to retain its current legal status andfreezing the supply of the sucres at current levels. That would require anew law that prohibited the central bank from issuing any new sucreliabilities. In addition, the new law would make the dollar legal andrequire that the sucre and dollar float freely against each other, withoutany government interference.

Under such a setup, a much-needed hard budget constraint wouldimposeitself automatically in Ecuador. Indeed, the central bank would be put outof business. It would no longer be capable of extending credit to thefiscal authorities, state-owned enterprises or banks. In consequence,Ecuador's currency crisis would come to an abrupt halt and its unrulypoliticians would be forced to get serious about long-overdue economicreforms. Dollarization via a parallel currency system would be technicallyfeasible and desirable in Ecuador. Whether it is politically feasibleremains to be seen.